Capital Account Liberalisation: New Thoughts

Now that ten years have passed since the Asian financial crisis, what have we learned about capital account liberalization? Eswar Prasad and Raghuram Rajan look at research on this question:

Capital account liberalisation: New thoughts on an old topic, by Eswar Prasad and Raghuram Rajan, Vox EU: It was fashionable in the mid-1990s for mainstream economists of nearly all stripes to recommend capital account liberalisation as an essential step in the process of economic development. Indeed, in September 1997, the governing body of the International Monetary Fund sought to make “the liberalisation of capital movements one of the purposes of the IMF and extend, as needed, the IMF’s jurisdiction …regarding the liberalisation of such movements.” The East Asian financial crisis of the late 1990s, where even seemingly well-managed countries like South Korea were engulfed by massive capital outflows and tremendous currency volatility, raised questions about the wisdom of developing countries opening their capital accounts, and certainly ended all discussion about giving multilateral organisations more of a mandate to push for liberalisation.

Ten years have passed and it is worth re-examining the benefits of openness to international financial flows, now that time has quelled passions and intervening research can shed more light on the debate. Moreover, the increasing desire of investors to look beyond their national borders for higher returns and diversification, as well as the increasing asymmetry in cross-border trade flows, necessitating corresponding financing flows, suggest that this is a particularly apt time to reconsider the issue.[1]

The subtleties of financial openness

Recent research suggests that the primary benefits and costs of financial openness are not what most thought they were. For instance, one benefit was seen to be the role foreign capital inflows could play in helping poor countries grow by expanding investment. It is very hard to conclude from the available studies that financial openness has a robust positive association with, let alone a causal effect on, the growth of non-industrial countries. More generally, some economists now believe the key benefit of financial openness is not the greater availability of financing. Indeed, recent studies show that non-industrial countries that rely on domestic savings rather than foreign capital do not have worse growth outcomes in the long run.[2] This suggests that domestic savings are not the primary constraint on growth in these economies, as is implicitly assumed in the benchmark neoclassical framework. Moreover, access to international capital markets hasn’t helped emerging market economies to share their income risk more efficiently, a presumed benefit of financial globalisation.

At the same time, it has been difficult to conclusively pin the blame for the financial crises of the last two decades on open capital accounts by themselves. There is also some recent research showing that capital controls can distort investment decisions, though this literature remains tentative at best. So the case for capital controls is quite weak as well. Though there is little evidence for either the main supposed benefits of financial openness or the main supposed costs, economists do not believe the debate over it is irrelevant, because they now see that the benefits and costs may both be more subtle than earlier thought. In particular, there is mounting evidence that financial openness catalyses indirect benefits that, in turn, can have a significant positive effect on growth. These indirect benefits include financial market development, improved governance, and incentives for greater macroeconomic policy discipline. Some of the newer literature based on microeconomic (firm- or industry-level) data provides evidence that is supportive of these channels. Analysis of such data has also been helpful in understanding how capital controls raise the effective price of capital and have distortionary effects on investment decisions of domestic and foreign investors.

A complication is that there appear to be certain “threshold” levels of institutional development that an economy needs to attain before it can get the full benefits and reduce the risks of financial openness. This suggests that a country should focus on building up its institutional capacity and strengthening its financial markets before opening up its capital account. However, while financial openness is clearly not a prerequisite for attaining the thresholds, it is equally clear that it can greatly facilitate the process. This creates a trade-off for developing countries. Without opening their capital accounts, the process of improving domestic institutions may take far longer. With underdeveloped institutions, however, the country will not realise the full benefits of financial openness and may indeed suffer costs. The question then becomes how to manage the risks during the transition to an open capital account if the preconditions are not fully in place.

Trending towards financial globalisation

Notwithstanding these complications, there are two arguments for why it increasingly makes sense for countries to shift their focus to how they will manage the process of capital account liberalisation rather than whether they should liberalise at all. First, capital accounts will become more open so long as there are strong incentives for cross-border flows of capital. Increasing global financial flows, the rising sophistication of international investors, and the expansion of international trade – which can serve as a conduit for disguising capital account transactions – will inevitably result in de facto opening of the capital account, irrespective of the capital control regime. Hence, it may be best for policymakers in emerging market economies to take steps to actively manage the process of capital account liberalisation – rather than just try to delay or push back against the inevitable – in order to improve the benefit-cost trade-off. Otherwise, policymakers may be stuck with the worst of all possible worlds – the distortions created by de jure capital controls and the complications of domestic macroeconomic management that are a consequence of increasing cross-border flows.

Second, given the balance of risks will vary over time, the global economic environment and the circumstances of individual countries may create windows of opportunity for countries to pursue capital account liberalisation. For instance, private capital flows in the last few years are increasingly taking the form of foreign direct investment or portfolio equity flows, both of which are less volatile and more beneficial than portfolio debt flows. A number of emerging market economies have accumulated large stocks of foreign exchange reserves and have also become more open to trade, which has substantially reduced the risks related to sudden stops or reversals of capital inflows and also mitigated risks of contagion. A country that has shifted the terms of the debate to “how” from “whether” can take advantage of these windows of opportunity to press for further liberalisation.

None of this is to say that the risks of financial openness have evaporated and that countries should rush headlong into it. Indeed, one of the main lessons of the financial crises of the 1980s and 1990s is that, once the taps are opened to capital flows, it can be very difficult to shut them off. Moreover, allowing capital account opening to get too far ahead of other policy reforms – especially domestic financial sector reforms and greater exchange rate flexibility – could have potentially devastating consequences if there were to be sudden shifts in international investor sentiment. There are also substantial inefficiencies in international financial markets, which remain far from complete in terms of the range of available instruments for sharing risk and are still beset by informational asymmetries, herding behaviour and other such pathologies. This suggests the need for creative approaches to capital account liberalisation that allow countries to undertake liberalisation in a controlled way, helping them enjoy some of the indirect benefits without exposing themselves to substantial risks.

Capital account liberalisation in reform strategies

We do not view capital account liberalisation as an appropriate policy objective for all countries in all circumstances. For poor countries with weak policies and institutions, it may not be a major priority, although even some poor but resource-rich countries have to deal with capital inflows and their mixed benefits. Having a strategy for managing an open capital account, rather than just coping in an ad hoc way with the whims of international investors, may be relevant even for these countries. Indeed, a key lesson from country experiences is that an open capital account works best in a supportive environment when other policies are disciplined and not working at cross-purposes. An open capital account is hardly an end in itself and generates adverse outcomes when implemented in isolation without due heed to domestic conditions and to complementary policies such as trade liberalisation. The same is true on the flip side, however. Imposing capital controls to try to mitigate the costs of other distortionary policies (such as financial repression or fiscal profligacy) often makes things worse.

Ultimately, capital account liberalisation can be much more effective if seen as part of a broader reform process. The objective of a fully open capital account can offer a unifying development goal that can help structure and sequence essential policy reforms and evaluate progress towards those reforms. There is also an important political economy argument to be made that a time-bound framework towards an open capital account can help build a consensus around that goal and make the political path for reforms smoother. In sum, capital account liberalisation may best be seen not just as an independent objective but as part of an organising framework for policy changes in a number of dimensions.